3 Issues To Watch As Energy Markets Remain Volatile

Here are some key energy issues for traders to keep in mind as energy markets continue to show extreme volatility:

1. Will skyrocketing European energy costs change Europe’s energy market?

European Union leaders are now coming to terms with the fact that skyrocketing natural gas prices are making energy costs too high for consumers. European Commission president Ursula Von der Leyen said recently that the European energy market is no longer working under current conditions and emergency intervention is needed, specifically to decouple the price of energy from the price of natural gas.

Under the current design, the price of electricity is determined by the price of the most expensive fuel that is used to meet demand on any given day. The idea behind this pricing scheme was a goal to promote the use of renewables, which in Europe are cheaper than fossil fuels. However, European countries are still dependent on fossil fuels to meet demand, and the spike in natural gas prices has caused electricity prices to hit 600 euros per megawatt hour in intraday trading.

Most European countries are advocating a cap on natural gas prices, but this would only bring down prices for consumers. Someone, likely the European governments, would still have to cover the difference if they plan to supply their economies with natural gas for electricity. (There is currently no other alternative to meet the power needs unless we see blackouts).

One idea, which Poland supports, is to put a cap on the prices of the EU’s Emissions Trading System. European power generators that burn fossil fuels must buy carbon offsets at prices determined by the trading system to compensate for the carbon these fuels emit when burned. These are currently trading at 90 euros/ton. Poland suggests that a cap of 30 euros/ton could help bring down prices. I would argue that Europe should suspend this system altogether for the duration of this energy crisis, which Ben van Beurden, the CEO of Shell believes could last for years.

2. How will the European energy crisis impact other commodities?

The geopolitical crisis in Europe has already impacted grain markets as both Russia and Ukraine are major exporters of wheat. However, we are now seeing the energy crisis spill into other commodities.

For example, aluminum production is being curbed in Europe due to energy costs and fuel rationing. Alcoa (NYSE:AA), a major aluminum producer based in America, announced that it is curtailing production at its Lista smelter in Norway by one-third because the price of energy to run that smelter is too high. This comes on top of curtailments on the scale of 500,000 tons over the past year. Aluminum is a particularly energy-intensive substance to produce so it is most vulnerable to energy price spikes.

The price of fertilizers is also soaring, in part because some of the raw materials used to make fertilizer are derived from natural gas. Fertilizer production has also been curtailed in some places in Europe because of the high prices and lack of feedstock. This will have repercussions across other commodities markets that rely on fertilizer for production.

3. Will OPEC+ cut production at its meeting on Sept 5?

After the Saudi oil minister, Prince Abdulaziz bin Salman, stirred up oil markets with his comments last week, traders are wondering whether the group will push through a production cut next week. I see this as unlikely because OPEC+ probably won’t be able to restructure its production quotas in a new agreement by next Monday. This will most likely come later this year, perhaps at the November meeting.

Most likely, the group will leave quotas unchanged. Traders should remember that OPEC+’s actual production rates are more relevant than its quotas to oil prices right now, because so many member nations are producing below their quotas. In fact, many cannot meet their quotas.

Looking ahead, however, the OPEC+ Joint Technical Committee (JTC) just issued a report that forecasts a 100,000 bpd increase in supply surplus for 2022. The committee now expects the market to see a 900,000 bpd average surplus this year. The JTC’s assessment of the physical oil market could provide some clues as to whether OPEC+ will cut production quotas in the future. Traders should watch future JTC reports as well as OPEC’s official supply and demand forecasts for 2023 for signals of whether the group plans to cut quotas or not.